Is India’s fiscal federalism breaking apart?

Seven States cry foul over unfair tax sharing, forced dependence on Central schemes, and GST woes, raising fears of a fractured federation.

Opposition leaders during the protest against the Narendra Modi government over distribution of Central funds to States, at Jantar Mantar in New Delhi on February 8. | Photo Credit: Shashi Shekhar Kashyap

Indian federalism is on the verge of a breakdown. Ministers from opposition-ruled States have taken to the streets in New Delhi to protest against discrimination by the Centre. And Prime Minister Narendra Modi, who leads the use of a divisive majoritarian agenda for political gains, has attacked the protesters saying that they are breaking up the country by using the narrative of a North-South divide for political purposes.

The fact is that opposition parties leading State governments are under siege. Central agencies are being used to scare and incarcerate State-level opposition leaders. Central directives and schemes are being used to undermine State-level initiatives and systems in areas such as education and food distribution. And an aggressive effort to force a distorted fiscal regime on States is undermining the States’ ability to pursue their own development agendas.

States governed by parties that are not part of the National Democratic Alliance (NDA) coalition ruling at the Centre claim to be feeling the heat even more because they face discrimination in the distribution of discretionary transfers from the Centre to the States. These parties decided to express their frustration in New Delhi, with Chief Ministers and/or Cabinet Ministers joining agitations in forms characteristically adopted by protesting farmers, trade union members, and other marginalised sections.

Protests in Delhi

On February 7, a slew of Cabinet Ministers of the Congress-led Karnataka government, fronted by Chief Minister Siddaramaiah, staged a protest at New Delhi’s Jantar Mantar. Siddaramaiah claimed that they were protesting against the “gross injustice” in the devolution of taxes and grants-in-aid from the Centre to the States.

A day later, Pinarayi Vijayan, CPI(M) leader and Chief Minister of the Left Democratic Front (LDF) government in Kerala, and his Cabinet colleagues, along with MLAs, MPs, and Ministers from the CPI(M) and other non-NDA parties such as the AAP and the Dravida Munnetra Kazhagam (DMK), staged a similar protest. Vijayan, however, made it clear that it was not only opposition-led governments that were being squeezed but also those led by the BJP or its allies in the NDA.

The conflict over resources in India’s quasi-federal political structure is by no means new. The potential for it was sensed even by the framers of the Constitution, who recognised that the division of taxation rights and spending responsibilities between the two principal tiers of government in India’s vast democracy was asymmetrical.

While the Central government was capable of mobilising a much larger share of gross tax revenues than the States, the latter had to shoulder a larger range of developmental responsibilities that in themselves would yield limited or no revenues. For instance, in 2021, 37 per cent of the combined revenues of the Centre and the States were collected by the States, whereas 62.4 per cent of expenditures were incurred at the State level. It is to address this asymmetry that the Constitution provided for what were meant to be independent Finance Commissions, set up once in five years, to recommend measures to devolve resources from the Centre to the States and ensure a fair distribution of the devolved resources between differentially developed States with different capacities to mobilise resources through taxation.

Mobile vans of “Bharat Rice” featuring Prime Minister Modi’s image were flagged off by Union Minister Piyush Goyal in New Delhi on February 6. Opposition-ruled States such as Kerala have protested against the Centre’s insistence on using Modi’s picture in these schemes. | Photo Credit: PTI

How resources are shared

Following a complex history of that system of resource sharing, four kinds of flows have emerged as central today. The first is a statutorily defined share for the States in a defined set of tax revenues garnered by the Centre, with the principles governing the share devolved and distributed to individual States recommended by successive Finance Commissions.

The second is a set of statutorily mandated grants, especially the revenue deficit grant to identified States to cover the gap in their revenue account post-devolution. Grants-in-aid to States have fallen from Rs.1,95,000 crore in 2015-16 to Rs.1,65,000 crore in 2023-24.

Besides these statutory transfers, there are forms of discretionary spending, earlier substantially mediated by the Planning Commission, that gave States some say in such spending. With the abolition of the Planning Commission, such transfers have been made solely at the discretion of the Centre. One such set of flows involves the Centre’s share of expenditure in Centrally sponsored schemes being implemented in States, with the State governments meeting a specified proportion of the projected expenditure.

The other significant vertical flow comes through Central sector schemes that are implemented by the Centre in the jurisdiction of individual States, with all the expenditure being met by the Central government.

Over time, Finance Commissions have recommended increases in the share of divisible taxes to be devolved to State governments. The last major increase was recommended by the 14th Finance Commission, which raised the States’ share to 42 per cent from 32 per cent. There are allegations, based on statements from the pro-government CEO of NITI Aayog (which replaced the Planning Comission), who served in the Prime Minister’s Office during the relevant time, that at the beginning of his first term in 2014, Prime Minister Modi tried to get the 14th Finance Commission to reduce the share of the States in the divisible pool of taxes. But the then head of the Commission, Y.V. Reddy, held firm.

The 15th Finance Commission retained the 42 per cent figure, while allocating as part of this 1 per cent to Jammu and Kashmir and Ladakh, which had been reduced to Union Territory status following the abrogation of Article 370.

While State governments welcomed the 14th Finance Commission’s recommendation on revenue sharing, they have not been happy with the actual experience with devolution. This is mainly because successive Central governments tweaked the pattern of taxation to keep a rising share of revenues out of the divisible pool of tax revenues. It meant that States do not receive a share of these revenues.

Especially contentious here is the use of cesses and surcharges. Cesses and surcharges are meant to be special purpose imposts levied to generate revenues to cover specific expenditures. Surcharges are so named because they are imposed, for example, on top of income and corporate taxes.

Given these features, such levies are not included in the divisible pool since they are targeted imposts. Both are meant to be temporary in nature but are most often not withdrawn once imposed. They have been increasingly used, especially by the last two NDA governments, to garner tax revenues for the Centre that it need not share with States.

Cesses and surcharges

When the first United Progressive Alliance (UPA) government was formed in 2004, the share of revenues from cesses and surcharges stood at 11.5 per cent of gross tax revenues and remained at 11.6 per cent at the end of its term. Under the second UPA government, between 2009 and 2014, the ratio rose to 12.4 per cent, and then to 13.5 per cent in the first year of the first NDA government. Then, after falling to 12.2 per cent in the next year, the ratio has consistently risen, going above 20 per cent.

The claim that cesses are meant for specific expenditures is only a fig leaf. For instance, receipts from the cess on petrol and diesel were initially to accrue to the Central Road Fund (CRF) set up to finance the construction of national highways, State roads, and such infrastructure. However, in 2018, the CRF was renamed Central Road and Infrastructure Fund (CRIF) and brought under the Ministry of Finance, allowing these resources to be used for other infrastructure projects. This increased the flexibility with which these resources could be deployed by the Centre.

Besides this overall loss for all States put together, individual States find that their share in revenues transferred has fallen over time and that they have been penalised for good performance.

Horizontal devolution is determined by Finance Commissions using parameters such as income distance (from an average), population and demographics, nutrition, health, and fiscal performance. Earlier, population was one of the parameters considered when determining the horizontal distribution of devolved taxes among States, with more populous States getting the benefit of higher transfers.

Until the 14th Finance Commission, the population enumerated by the 1971 Census was considered. That vintage figure was retained because later figures, if used, would have gone against States that had a better record in terms of reduced population growth resulting from lower fertility.

The 14th Finance Commission also used the 1971 population figures but gave some weight to Census 2011 figures because it would be inappropriate to altogether ignore that census. The terms of reference of the 15th Finance Commission, constituted in 2017, required it to use data from Census 2011.

That shift, besides other factors, affected some States adversely. For instance, calculations of shares of States arrived at by the 15th Finance Commission saw Karnataka’s share declining from 4.71 per cent to 3.65 per cent and Kerala’s from 2.5 per cent to 1.92 per cent.

Karnataka Chief Minister Siddaramaiah and Deputy Chief Minister D.K. Shivakumar at a protest by the Congress leaders from the State against the Centre, at Jantar Mantar in New Delhi on February 7. | Photo Credit: PTI

Dependence on Centre

A consequence of the loss of revenues on these counts is that States have become overly dependent on Centrally sponsored schemes to undertake welfare expenditures through initiatives such as the MGNREGS, PM Awas Yojana, Jal Jeevan Mission, and National Health Mission.

Highlights

• Over time, successive Central governments have adjusted the taxation framework, resulting in States being deprived of a portion of the divisible tax revenue pool. This has led to a decline in individual States’ revenue shares and penalised them for achieving well.
• Consequently, States have increasingly relied on centrally sponsored schemes for welfare expenditures, while spending on schemes entirely governed by the Centre has tripled from 2015-16 to Rs. 14,68,000 crore in 2023-24.
• The implementation of the GST regime has further exacerbated the fiscal challenges faced by States, forcing them to hit the streets protesting the Centre’s fiscal approach.

Although the schemes are Centrally sponsored, and often accompanied by mandatory attribution to the Centre or the Prime Minister, State governments are now required to bankroll a higher proportion of the expenditure on them on a sharing principle. Earlier, the State-Centre ratio in expenditure was 40:60. That has been changed to 50:50. As a result, States must allocate more funds for activities under these schemes if they are to take the benefit of partial Central funding. Cash-strapped States can avail themselves of spending under these schemes only to a limited extent. The States also have no role in the design of such schemes.

Finally, there are transfers that occur from the Centre to States through Central sector schemes fully funded and implemented at the discretion of the Centre. They include PM Kisan, Crop Insurance Scheme, Regional Connectivity Scheme, and Production Linked Incentive Scheme.

The spending on such schemes that are fully controlled by the Centre has reportedly increased from Rs.5,21,000 crore in 2015-16 to Rs.14,68,000 crore in 2023-24. There is a perception, backed by evidence, that distribution of expenditure on Central sector schemes across States is linked to the degree of Centre-friendly relations of the party in power in the States.

To top all of this, the Centre has increasingly resorted to restricting borrowing by States to somewhere around the equivalent of 3 per cent of the State domestic product (SDP). This ability of the Centre to set ceilings on borrowing by State governments stems originally from a constitutional provision that prescribes that a State cannot raise a new loan without the consent of the Centre if there is any outstanding part of a previous loan that the Centre has made to the State, or in respect of which the Centre has given a guarantee. Since debt outstanding is always the situation, this amounts to giving the Centre the right to curb borrowing by State governments.

Factors for which States too must share some, even if not all, responsibility have also contributed to the crisis facing States in recent years. One was the decision of States, following pressure from the Centre exerted through the Finance Commissions and influenced by the hold of neoliberal ideology over even non-BJP parties that ruled in many of them, to enact State-level Fiscal Responsibility and Budget Management (FRBM) Acts that set ceilings on their borrowing relative to the State’s GDP.

The self-imposed legislative target of eventually bringing State-level borrowing to around 3 per cent of State-level GDP, incorporated into all of the State-level FRBM Acts, has provided the Centre a benchmark around which ceilings are imposed.

Even when special circumstances force the Centre to relax the ceiling, raising it to 4.5 per cent or 5 per cent of Gross SDP as it did during the COVID-19 pandemic, enhanced borrowing has been made conditional on the implementation of reform measures such as participation in the “One Nation One Ration Card” scheme, working to increase urban local body revenues, adopting certain ease-of-doing-business measures, and changing policy with respect to governance and pricing in the power sector.

Kerala’s case

Kerala Finance Minister K.N. Balagopal argues that the State has been deprived of Rs.57,400 crore in Central transfers and loan approvals in 2023-24 alone. On the basis of that claim, the LDF government moved the Supreme Court in December 2023, charging the Centre with conscious fiscal discrimination.

The other development adversely affecting the fiscal position of States was the implementation of the goods and services tax (GST) regime, in which even State governments ruled by non-BJP parties were complicit. Under the GST regime, State governments ceded, to a substantial degree, the rights they had to impose State taxes of their own given their special circumstances. Neoliberal ideology was used to dress up the GST regime as one that would not just be “revenue neutral” but improve the “efficiency” of the indirect tax regime and enhance revenues at both the Central and State levels.

Influenced by those arguments, State governments were willing to endorse the scheme in return for the offer that until the new regime stabilised, by June 2022, they would be compensated for any shortfall in revenues relative to a level reflecting a 14 per cent annual growth of collections from taxes that were to be subsumed under the GST. They were also willing to agree to a voting structure in the GST Council, which determines the pattern and level of goods and services taxation across States. In practice, this gave the Centre veto powers in decision-making.

Using an estimate from the National Institute of Public Finance and Policy, which placed the annual average revenues realised from taxes subsumed under GST from 2012-13 to 2016-17 at Rs.7.70 lakh crore, it is possible to compare actual receipts from GST collections in the period 2018-19 to 2022-23, with levels reflecting an annual 14 per cent.

This points to a shortfall relative to “promised” revenues of between 19 and 33 per cent, with the shortfall in 2022-23 being around 26 per cent. Not surprisingly, compensation for the shortfall financed with the compensation cess and additional borrowing by the Centre post-COVID was crucial for States. It follows that the end of the practice of providing compensation after five years, even though the promised stabilisation and growth of revenues has not been realised, has led to significant fiscal stress in most States.

At a protest by Trinamool Congress activists over the alleged non-payment of funds from the Centre for the MGNREGS, which reportedly held up wages meant for workers in West Bengal, in Kolkata on June 6, 2022. | Photo Credit: PTI

GST regime’s failure

The GST regime has clearly failed to live up to its promise. Not only has the growth in aggregate revenues fallen short of the 14 per cent promise, the revenue shortfall is strangely higher for States than the Centre. The States, however, are trapped since they have ceded their right to taxation across a broad range of taxes. Not surprisingly, many of them had demanded extension of the compensation arrangement beyond June 2022, but the Central government refused to accede to that demand.

The final blow, as it were, has come in Kerala, where the Centre has reinterpreted Article 293 of the Constitution to impose a ceiling on the State’s net borrowing, or borrowing from all sources and through all State-linked channels. The Centre’s claim is that Article 293 covers all borrowing on the public account. That is deemed to include money collected through means such as small savings, security deposits, provident funds, and treasury deposits, which are not part of the consolidated fund and are deposited in the “public accounts” of the State.

More importantly, in Kerala’s case, it has been defined to include borrowing by the Kerala Infrastructure Investment Fund Board (KIIFB), a public entity established by statute. This has been done by including in State government borrowing levels the borrowing by State-owned enterprises where the principal and/or interest are serviced out of the Budget, or though assignment of taxes or cess or any other State revenue.

The latter is the case with KIIFB, a major channel for spending on State infrastructure, since it receives by statute a share of the revenues from the State’s motor vehicle tax and cess on petroleum products.

In 2018, an assessment by the Centre-controlled Comptroller and Auditor General of the State’s Finance Audit Report contended that KIIFB’s borrowing must be included when computing the level of the State’s borrowing. On the basis of that, the Centre has frozen borrowing by Kerala. The State government has challenged this contention. When applied in combination with borrowing ceilings specified by the Centre, it limits the State government’s resource mobilisation abilities to an extent where it cannot fully meet budgeted current expenditures.

The issue, however, is not one of mere competition for resources between the Centre and the States. Even with the BJP gaining control over the Lok Sabha and a number of State governments, its desire to extend control remains unsatiated. It had made this clear with its drive to establish a Congress-mukt, or Congress-free, political landscape in the country. That has now been extended to establishing an opposition-free political space.

To realise this objective, it has not only sought to undermine the legitimacy of individual opposition politicians with charges of corruption or “anti-national” activity, but also that of opposition-ruled State governments by eroding their ability to adopt economic policy measures and initiatives that could win them political legitimacy. Expenditures on building State infrastructure or social expenditures on subsidised food provision, a modicum of social protection, and employment guarantee schemes, do contribute to winning a degree of political legitimacy for a party in power in a State.

The attack on the fiscal capacity of State governments helps limit such expenditures, even while Central claims on expanding infrastructural investments and social sector spending are advanced, with an increase in “Central” schemes, especially those attributed to the patronage of the highest authority, the Prime Minister. Even to the extent that State governments manage to outlay resources for welfare measures, Central spokespersons have attacked these as “populist” measures reflective of a revdi (sweet gifts) culture that seeks to win political legitimacy at the expense of much-needed fiscal consolidation.

This political agenda, in which the Centre is at liberty to spend and States are fiscally shackled, has recently been weaponised. The open declaration now is that citizens of a particular State will be privileged in Central spending if they vote for and elect a BJP-led government at the State level. The right to development has been subordinated to electoral behaviour that ensures a “double-engine sarkar”, or a State-level government that is politically aligned to the one at the Centre and is, therefore, favoured by the latter.

Developmental spending would not be the result of a constitutionally structured transfer of resources from the Centre to the States but depends on the political character of the State government. That leaves opposition-ruled States with no option other than taking to the streets to protest against discrimination.

C.P. Chandrasekhar taught for more than three decades at the Centre for Economic Studies and Planning, Jawaharlal Nehru University, New Delhi. He is currently Senior Research Fellow at the Political Economy Research Institute, University of Massachusetts Amherst, US.